"As to Bonaparte, he was well assured that nothing remained for him but to choose between that hazardous enterprise and his certain ruin."
-Memoirs of Napoleon Bonaparte, by Bourrienne

Friday, September 19, 2008

AIGs bailout and what it means for investors

As an AIG shareholder, I was shocked an dismayed at the crisis at AIG and bailout from the Fed. Now I sit here with an enormous loss on my hands and an AIG stock worth only $2. So what to do now? Sell or hold? How much is this ghost of AIG worth?

I have no idea nor does anyone else. The reason why is that there has been no clarification of what really happened and what this deal with the Federal Reserve really entails. Nor do we know what really caused the liquidity crisis and whether the bailout has helped or hurt their cash problems. AIG is now a laughing stock and people appear to be pulling their money out as fast as they can.

So let me try a few scenarios to try at a valuation. First the simplest one. Before the liquidity crisis, I had estimated the stock to be worth about $40/share. So if the shareholders get to keep only 20% then the stock should be worth about $8. Of course everything has changed. AIGs reputation has been severely damaged. They may still face a liquidity problem. On the flip side, they may be liquidating a lot of their subsidiaries and so the AIG reputation may not matter as much. Also the break up value of AIG may be even higher than my estimated fair value. People have estimated the break value at $150B. Others say $180B. There are $2.7B shares so that is $11/share even with the 80% dilution, using $150B for the total. Of course all of this depends on the final losses from the CDS portfolio. Still, I have estimated these to be less than $20B. Certainly not $100B that would be required to come up with the current price.

So even with the 80% dilution, there is a chance that the company is worth substantially more.

However the real reason that people might consider investing in this cigarette butt of a stock is that this deal with the NY Fed may not stand. If AIG can liquidate assets quickly or find the money somewhere else, they may be able to get back that 80% equity stake.

Before I discuss how this is possible, let me comment on the deal. We don't really know the facts since there is no term sheet or anything in the public domain. From press releases from the Fed and AIG we know that the loan is 8% above LIBOR and has a 2-year term. There are some loan covenants but they are not disclosed other than that the Fed reserves the right to prevent dividends to shareholders. There is also some vaguely worded mention that the taxpayers will get "up to" a 79.9% equity stake. There was an 8-k from AIG saying that they issues a warrant to the Fed and that this required a shareholder vote. Then another 8-k came out to correct this and simply said that shareholder action would depend on the form of the equity. In other words it is not clear at all and the deal is likely still being formed.

There has been some discussion from corporate lawyers on whether any of this is legal. It is possible that the Fed will screw it up and create an illegal contract which can be thrown out in court later on. There isn't exactly a lot of precedence on this kind of thing.

There is talk that some major shareholders led by Hank Greenberg are trying to come up with an alternative plan. Greenberg mentioned on the Charlie Rose Show that they could raise capital in various ways: from sovereign wealth funds, from selling assets, from current shareholders etc.

So lets looks at this and try to game how it is likely to work.

First of all lets look at the incentives of shareholders. Anyone holding AIG shares likely believes that the CDS losses are manageable. If not, they would probably not still be holding shares. So they likely believe that the company is worth at least $60B and so losing 80% to the government would be a major and avoidable loss. They would likely want to do everything they can to undo this deal including investing more of their own capital.

Same with SWFs and other PE investors. They likely see the value in AIG as long as they can provide the needed liquidity. With a recession looming and the $700B federal bailout coming, an insurance company with 60% of sales overseas looks like a great place to invest long term.

The main thing to look at is the incentives of the NY Fed and the US government. This is much harder to figure out.

They clearly didn't want to give this loan. If someone else could come in and take over they might be happy about it. However, they need to be sure that this party provides enough liquidity so that failure is not possible. That is because they don't ever want to be in this same situation again. So this might require something like $150B. It needs to be an overwhelming amount of money so that AIGs credit worthiness is completely secured.

There is the issue of the warrant (if it exists). Naturally the Fed does not want to give up an asset that may be worth $50-80B. An assets is an asset after all and nobody gives them up for nothing in return. However this asset might be more trouble than it is worth. There could be all kinds of legal action on the part of AIG shareholders. There is the issue of liability. A warrant does not usually mean ownership however the marketplace is not likely to see it this way. As long as the Fed has this loan outstanding and the warrant in place, the world will expect the Fed to keep AIG functioning.

There is the issue of making an example of AIG. People (i.e. taxpayers and homeowners) are mad and want blood. It looks good for Paulson to say that he was hard nosed with AIG just like he was with Lehman and FNM and FRE. However there are problems with this as well. A couple of days after AIG they announced the mother of all bailouts. Coincidentally, this was when the fires had reached the gates of Goldman Sachs where Paulson was CEO. That doesn't exactly look hard nosed. It looks rather self serving and inconsistent. Why is it OK to save Wamu, Goldman, Morgan Stanley and others but take 80% of AIG? AIG is actually the only one of these that is probably solvent. Their problem was liquidity not solvency. If they were a small company they likely would have gone into Chapter 11 until they could obtain financing and come out unharmed. Avoiding Chapter 11 likely had more to do with systemic issues.

If the party led by Greenberg can present an alternative plan that gets some or all of this equity back, then Paulson and company might go for it. It would relieve the government of the problem and might help them in a couple of ways. It would show the world that private capital still exists and is still willing to invest in US companies. It would likely be good PR for Paulson as it would be a step away from the socialist tactics that they have been forced to apply. Although the loan to AIG probably has no real risk (since it is a senior loan with a company that has a trillion in assets), the public probably doesn't understand this.

If the Fed refuses to give up their equity stake, can AIG shareholders play hardball? Perhaps. Remember that the executives at AIG are also large shareholders. What if they all threaten to quit? What would happen to AIG then? They may figure that they have lost 90% of their value now. What is another 10%? I think that if they acted with solidarity, they could exert enormous pressure on the government. How could the Fed run AIG if everyone knowledgeable quit and refused to give them any information. They could also threaten to refuse the loan and take the company into Chapter 11. It is possible that they can get foreign governments to put pressure on the US government. Do foreign leaders want AIG controlled by the NY Fed? I doubt it. How powerful is Greenberg really? He used to be the worlds most powerful businessman. Does he still have this kind of power? Is he as shrewd as he used to be? I am betting that Greenberg will play hardball if needed.

So overall, I think there are many reasons to be hopeful that the AIG stock will recover. It is far from a certainty but even with a 20% chance of success, this adds enough speculative value to the stock to make it worth far higher than $4 where it is trading now.

------------------------------------------------------New valuation

Ok, so lets assume that the government gives in and lets this group of investors replace the loan with capital. What kind of deal might be expected from new investors? Well, probably not a very good deal. Lets do a new valuation assuming this deal happens.

First we need to value the company as is. The equity of the company as of last Q was $78B. The real equity is probably somewhat higher. Lets just say $80B as a round number. There are 2.7B common shares. The normalized earnings for AIGs core company is about $4/share or $11B/year after ignoring the financial products group fluctuations. That is a ROE of 13.5% which is about average for the company (using $80B for equity).

Such a company is generally worth about 1.5 book value. That is about $120B. Valuing it on 9 x earnings would put it at $97B. A DCF would be much higher since the interest rates (i.e. discount rate) is so small. Lets say it is valued somewhere between these as $100B. This of course assumes that they become essentially an insurance company again with plenty of capital. Lets call this valuation V so we can some up with a formula.

So lets say the investors want to put in C=$60B of new capital. Then it would be worth about V+C=$160B. Let say they demand some haircut, H, on the value. Perhaps they will pay only H=60% of the value of the total company. This determines the percentage of the company that they get to own, P. The present owners get to keep 1-P. The haircut is given by

H= C/((C+V)*P) and so P=C/((C+V)*H). Using H=60% and C=$60B and V=$100B, this is P=62.5%. Current shareholder would keep 37.5%.

That would mean that our share of the company should be worth $160B*0.375=$60B or $22/share.

A more extreme case would be a that they only pay H=40% for the value they get back. What a deal! That would be PPS=$3.70/share. That is below the current price. This shows how sensitive the PPS formula is to H. You can see that P=1 when H=C/(C+V). So current shareholders have no incentive to do this deal when H is greater than or equal to this.

Probably the most likely haircut would be H=50% which gives PPS=$14.8. This would be a great deal for the new investors and still a pretty good deal for the current investors given that the current share price is about $4.

The alternative to this would be just leaving the deal with the government as is. In that case the shares might be worth $8 or so depending on how the deal goes. That value should be considered a floor for the stock. Assuming that the government deal has a 80% probability of sticking and therefore the buyout deal has a 20% chance of going through, I come up with a weighted average PPS of $9.36. That is about twice the current share price which not coincidentally is about the same haircut demanded for the new investors. It may take a couple of years to reach this price since the company may see a lot of trouble in the year ahead.

-----------------------------------------Other info about the governments stake (both positive and negative)

First the good news. There has been lots of contradictory information on the form of the governments stake. Reading between the lines and interpreting all of this leads me to conclude that the 79.9% equity stake is a worst case scenario, not the most likely scenario. They might not yet even have the deal completed. I think they have structured this so that the company has the incentive to raise capital, sell assets and pay off the loan as quickly as possible. For example the WSJ mentioned that the form is an equity participation note . Today the new CEO said on CNBC that the government has convertible preferred shares. Obviously, I have no idea. But the CEO also said that IF they can't pay off the loan, the government will get 79.9%. So I don't know what to think but it appears that the 79.9% stake is a threat and not a certainty.

There is however something I am quite afraid of. There is the possibility that Paulson and company will decide to use AIG as the sacrificial lamb. Paulson is after all the former CEO of Goldman Sachs. Goldman is probably the biggest counterparty to AIG's CDS contracts. The New York Times has just reported on this meeting of shareholders today to discuss an alternative to the Fed's plan. Here is a quote:

"One person involved in the planning, who spoke on condition he not be identified, said that in the worst case, winding down the unit’s affairs could consume the Fed’s entire $85 billion loan."

So basically, the Fed could decide to make AIG pay off the counterparties in return for cancellation of the contracts. This could easily erase all of the equity of AIG. This would be great for Wall Street, great for the economy and terrible for AIG. AIG is much better off holding their subprime CDSs to maturity and paying them off as defaults happen.